A casino where the rest of us lose

If the movie The Big Short helped you understand how Wall Street drove the world economy off a cliff in 2008, then Jason Farbman has some recommended reading.

March 9, 2016

AS THE Democratic Party closes ranks around Hillary Clinton as its presidential candidate, we're still left wondering what she said to Wall Street when they paid her $600,000 for a few speeches.

Her close connection to Wall Street--before, during and after the financial meltdown of 2008, which pushed the economy off the edge and into the Great Recession--is something she hasn't been able to shake off.

It's been almost 10 years since Wall Street speculation drove the world economy into recession. In that time, few of those responsible have been punished, and the politics of austerity have reigned as government policy so that profitability could be restored.

The insurgent campaign of Bernie Sanders is one clear expression of the still-simmering anger over the enormous gap between the 1 Percent and the 99 Percent. Another is the reception for the film The Big Short. The movie about the crisis featured major stars (Christian Bale, Steve Carell, Ryan Gosling and Brad Pitt), earned major money ($127 million at the box office) and was nominated for five Academy Awards.

The response to the film amplifies the impact of the book on which it was based. Journalist Michael Lewis' book spent 28 weeks on the New York Times best-seller list when it was first released in 2010.

I picked up The Big Short: Inside the Doomsday Machine after seeing the film and was really impressed. In it, Lewis tells the story behind the 2008 collapse, making accessible the labyrinthine and opaque financial arrangements of Wall Street.

The Big Short features two types of characters. The antagonists are the incredibly greedy speculators on Wall Street who don't actually understand the contents of the massive numbers of loans they are placing bets on. The ones who pass for protagonists are those who see what's going on and attempt to make enormous sums by betting against the whole financial system.

In sum, there isn't anyone to root for. Despite this, Lewis makes The Big Short compelling by zooming in on just the right figures at just the right moments, as they unravel pieces of the speculation scam surrounding the subprime lending boom.

Seen through the eyes of financial professionals who also need to untangle the meaning of collateralized debt obligations and credit default swaps, the reader is left with a clear enough picture of greed and incompetence to wonder why the 2008 crash caught so many by surprise.

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BY 2008, Wall Street had made many billions in profits on the subprime mortgage industry, and on the concentric circles of speculative betting that surrounded it. The problem began with subprime loans, the mechanism banks use to lend to "greater risk" borrowers. Subprime loans are issued at a higher interest rate so banks have the potential of getting more money in return to weigh against the greater threat the borrower won't pay and defaults.

With wages stagnating and the cost of living rising, workers were forced to accept loans with higher interest. For the banks' part, subprime loans may have carried a higher likelihood of default, but they were more profitable. New lenders rushed to cash in.

As the subprime industry boomed in the late 1990s, lending became more competitive and increasingly predatory. Millions of people were convinced to take out subprime mortgages that they couldn't afford to repay. The most common of these, the adjustable rate mortgage (ARM), deceived many borrowers because the initial interest rate was low and only began to rise after a couple years. By 2006, 90 percent of subprime loans were ARM.

Black families who had a harder time getting loans due to redlining and other racist practices were especially targeted. Some loan officers developed relationships with local churches to take advantage of the unstinting trust of their parishioners. Immigrants who spoke little English and missed the fine print were also hustled. Lewis describes a California strawberry picker who was given a mortgage loan for $750,000--on an income of $14,000 a year.

It should have been expected that a subprime loans with adjustable rates would have a higher number of defaults when the interest rates spiked. That didn't matter to loan officers, though. They were paid commissions for originating loans, so they had an incentive to hunt up new customers. It didn't seem to matter to Wall Street either--because billions of dollars in speculative bets developed around these unsustainable mortgages.

Throughout the history of financial markets, traditional home mortgages represented one of the soundest bets one could make. So, too, were mortgage bonds--bonds backed by a pool of mortgages that Wall Street firms traded, not unlike stocks. As Lewis writes:

In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a [collateralized debt obligation, or CDO], you gathered one hundred different mortgage bond--usually, the riskiest, lower floors of the original towe--and used them to erect an entirely new tower of bonds.

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BECAUSE A CDO going bad would mean defaults on hundreds of thousands of loans, a sort of insurance was developed called a credit default swap (CDS). Not unlike, say, auto insurance, with a CDS, buyers made regular premium payments in return for coverage against a certain amount of bonds going bad.

But unlike auto insurance, a CDS could be taken out on bonds that you didn't own, which actually made CDS an entirely different thing than insurance. You take out insurance on a car precisely because you do own that vehicle, and you don't want anything to happen to it. Credit default swaps on bond packages invested in by others--and made up of loans taken out by still others--amounted to a bet that something bad would happen to someone else.

Credit default swaps were essentially speculative bets against markets, and therefore far cheaper to produce and profit from. A $1 billion CDO required $50 billion in subprime mortgages, each of which required a subprime loan officer to find an unsuspecting target and convince them to take out a loan. A CDS, on the other hand, could be put together simply by shuffling together existing CDOs and accepting insurance bets. Without actually producing anything, Wall Street found a way to make billions of dollars.

Those speculative bets depended on mortgage bond ratings handed out by ratings agencies such as Moody's and Standard and Poor's. These ratings are supposed to based on how likely the loans contained in the bond will be repaid. The highest rating is AAA--the same rating given to U.S. government bonds--which meant the loans were as close to "guaranteed" as could be. Yet these same CDOs, even when they were packaged with hundreds of thousands of subprime mortgages, were overwhelmingly rated AAA.

With hundreds of thousands of loans involved in a single one, there was no way for the ratings agencies to examine CDOs in any depth. "The people at Moody's and [Standard & Poor's] didn't actually evaluate the individual home loans," writes Lewis, "or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools."

To perform these inspections, the ratings agencies were paid huge sums from the firms originating the CDOs. Lewis writes:

To judge from their behavior, all the rating agencies worried about was maximizing the number of deals they rated for Wall Street investment banks, and the fees they collected from them. Moody's, once a private company, had gone public in 2000. Since then its revenues had boomed, from $800 million in 2001 to $2.03 billion in 2006.

Ratings agencies were supposedly exercising objective judgment about the products of Wall Street firms that were, at the same time, extremely well-paying customers of those ratings agencies. It's shocking these agencies' ratings were ever taken seriously: Some 80 percent of new subprime debt packages were pronounced AAA.

Once rated AAA, the contents of CDOs were never inspected at the level of individual mortgages. Wall Street firms were placing bets--worth billions of dollars--on financial products they didn't understand, nor seem to care to understand.

A moment's thought might would have revealed that if your firm was exerting pressure on a ratings agency to deliver rosier verdicts on subprime products, then so was every other firm, on Wall Street and off. Instead, though, the scramble was on to make as many deals as big and frequently as possible.

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THE FRENZY around subprime mortgages grew at every level, with these investments coming to dominate formerly diversified investment portfolios--and all of it based on subprime debt. Of all the consumer debt that AIG was asked to insure via CDS, subprime mortgages went from 2 percent in 2004 to 95 percent just before the crash in 2008.

When subprime mortgages were a small percentage of the overall investment, defaults could be absorbed. When nearly all holdings were related in some way to subprime mortgages, the defaults could be devastating.

In 2007, as ARM interest increases kicked in, banks began to announce significant losses. In July of that year, Fed Reserve Chair Ben Bernanke estimated losses from the subprime market might amount to $100 billion. By the following March it would be clear those losses stood at least at $240 billion. Lewis writes:

By late September 2008 the nation's highest financial official, U.S. Treasury Secretary Henry Paulson, persuaded the U.S. Congress that he needed $ 700 billion to buy subprime mortgage assets from banks. Thus was born TARP, which stood for Troubled Asset Relief Program. Once handed the money, Paulson abandoned his promised strategy and instead essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs, and a few others unnaturally selected for survival. For instance, the $13 billion AIG owed to Goldman Sachs, as a result of its bet on subprime mortgage loans, was paid off in full by the U.S. government: 100 cents on the dollar.

These payouts, it was insisted, would save the economy from failing. But failing who? In the recession that followed, nearly 9 million jobs were lost during 2008 and 2009. Meanwhile, writes Lewis:

pretty much all the important people on both sides of the gamble left the table rich. [Those betting against subprime mortgages] each made tens of millions of dollars for themselves...[one] CDO managing business went bust, but he, too, left with tens of millions of dollars--and had the nerve to attempt to create a business that would buy up, cheaply, the very same subprime mortgage bonds in which he had lost billions of dollars' worth of other people's money.

[Another CDO trader] lost more money than any single trader in the history of Wall Street--and yet he was permitted to keep the tens of millions of dollars he had made. The CEOs of every major Wall Street firm were also on the wrong end of the gamble. All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the United States government. They all got rich, too.

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WHEN MORGAN Stanley CEO John Mack was called before investors to explain a $9 billion loss on subprime securities, a string of incoherent explanations revealed that Mack, like every other Wall Street CEO, didn't really understand the financial deals into which his firm has sunk billions of dollars.

"It's too much to expect the people who run big Wall Street firms to speak in plain English," Michael Lewis observed in The Big Short, "since so much of their livelihood depends on people believing that what they do cannot be translated into plain English."

Nearly all discussions of economics are shrouded in doublespeak and acronyms, which often convinces those of us who don't pretend to understand the meaning of CDOs, RMBS, HELs, HELOCs or Alt-As to believe that we can't understand any of it. But as Lewis makes clear, the opacity is intentional and designed to mask all kinds of scams--so much so that even Wall Street couldn't keep track of them all.

While this book is an account of the excesses of capitalism, it certainly isn't an anti-capitalist manifesto. This would not be the book I would give to someone today to convince them to become a socialist.

But for those of us who are committed anti-capitalists, The Big Short is an incredibly useful guide to understanding the machinations of Wall Street to find ever-greater profit streams--and how that weighs on the lives of millions of Americans every day.